Renting out Primary residence - tax implications

Buying & Selling Real Estate
6yFollow

Renting out Primary residence - tax implications

Corey M.
Member since 2020 · 106 posts · 32 votes

As noted in another post, I'm considering renting out my LA condo, which will be cash flow negative in the range of $500/mo. I bought the house for $320k with 20% down, did a cash out refi recently and got a new $420k loan. That means there's about $230k in equity left in the home. 

If I rent it out, it'll be at around $3k/mo, but with all expenses, it'll cost me $500/mo, so I'll be losing $6k year in cash. Assuming the property conservatively appreciates by 3%/yr, does this move make sense over a turnkey (not that I only want a passive investment) with an ROI of about 17% (including cash flow, appreciation, and house paydown)?

My understanding is that I can no longer get the $250k cap gains exclusion if I move out and don't live in the place in three years. But what if I want to keep this as a long term rental property and sell it in a decade? Am I out of luck and have to pay taxes on what would've been a $250k exclusion? To me, renting out the primary residence only makes sense if I can do it for the long term, especially when housing prices could drop 10-20%+ in one year (like they did around 2007 in LA). 

Assuming I can afford to lose $6k/yr on the negative cash flow, is turning this into a longterm rental going to be a bad decision if I don't plan on selling it within three years? Is there any way to hold onto that $250k exclusion if it's a long term rental? 

1Reply
35 views

Most Popular Reply

Tony Kim
Rental Property Investor · Los Angeles · Member since 2018 · 844 posts · 1k+ votes
6y
Originally posted by @Corey M.:

As noted in another post, I'm considering renting out my LA condo, which will be cash flow negative in the range of $500/mo. I bought the house for $320k with 20% down, did a cash out refi recently and got a new $420k loan. That means there's about $230k in equity left in the home. 

If I rent it out, it'll be at around $3k/mo, but with all expenses, it'll cost me $500/mo, so I'll be losing $6k year in cash. Assuming the property conservatively appreciates by 3%/yr, does this move make sense over a turnkey (not that I only want a passive investment) with an ROI of about 17% (including cash flow, appreciation, and house paydown)?

My understanding is that I can no longer get the $250k cap gains exclusion if I move out and don't live in the place in three years. But what if I want to keep this as a long term rental property and sell it in a decade? Am I out of luck and have to pay taxes on what would've been a $250k exclusion? To me, renting out the primary residence only makes sense if I can do it for the long term, especially when housing prices could drop 10-20%+ in one year (like they did around 2007 in LA). 

Assuming I can afford to lose $6k/yr on the negative cash flow, is turning this into a longterm rental going to be a bad decision if I don't plan on selling it within three years? Is there any way to hold onto that $250k exclusion if it's a long term rental? 

I think this is a bad decision, but not because you'd be a relinquishing the section 121 deduction. I'd recommend against it because you are projected to have a negative cash flow. I know that part of this is offset with principal mortgage pay down, but it just does not make sense to convert this to a rental while absorbing neg cash flow.

With that said, since your original question was asked under the assumption that you would be fine with absorbing the monthly neg cash-flow, I think a reasonable alternative might be to convert it to a rental for a few years and see how it goes. After a few years you can make the decision whether or not you want to sell.

I also converted my LA condo into a rental several years ago. When the 3-year point was approaching, we took a hard look at our options and decided to keep it as a rental. In hindsight, it was one of the best decisions I ever made. But, the property also had significant positive cash flow....so we didn't mind holding on to it indefinitely. We exchanged that condo for a multi-unit in South LA a few years ago.

1Reply
See this reply in the discussion

10 Replies

Jump to latestLatest
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    6y

    No, you can’t keep the $250k exclusion if you rent it for more than 3 years. You cloud however, move back into it for 2 years sometime in the future...this wouldn’t give you the full exclusion, but it would be a pro data share exclusion based on the years occupied verses the years as a rental. So how long you’ve already owned it would help determine if this would makes sense. This assumes the 121 rules don’t change between now and then. 

    0Reply
  • Corey M.
    OP
    Member since 2020 · 106 posts · 32 votes
    6y
    Originally posted by @Wayne Brooks:

    No, you can’t keep the $250k exclusion if you rent it for more than 3 years. You cloud however, move back into it for 2 years sometime in the future...this wouldn’t give you the full exclusion, but it would be a pro data share exclusion based on the years occupied verses the years as a rental. So how long you’ve already owned it would help determine if this would makes sense. This assumes the 121 rules don’t change between now and then. 

    I've lived in the property for 8 years. So what would happen if I rent it out for the next 10 and sell it at the end? I would not move back in at any point during that term. If the answer is that I'd still lose the $250 deduction, then why would anyone ever turn their primary residence into a long term rental. You'd be throwing away an $80k tax break right off the top.
    0Reply
  • AJ Singh
    Rental Property Investor · Orange County, CA · Member since 2016 · 512 posts · 374 votes
    6y

    @Corey M.

    you can sell your prinicpal residence, take the 250k exclusion and get a duplex, triplex or quad in Long beach, Bellflower, Paramount neighborhoods etc from the gain. That way you get a rental property rather than conversion. but again cash flow will be minimal

    i was also losing $500 a month in San diego condos from 2008 -2013 but in the larger picture, 

    there is an annual retun of principal on mortgage, tax deduction due to depreciation and that $6k evened out

    Also your property taxes are low due to ownership from 2012. 

    The question you have to ask is if the market does not go down, will you be able to buy a similiar property when you want to reinvest in the LA area.

    LA market investing is about capital appreciation and less about cash flow unless you go in Riverside and San bernadino counties where you can cash flow positive as in out of state 

    be cautious in your next steps

    0Reply
  • Wayne Brooks
    Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
    6y

    @Corey M. Once it’s a rental for 3 years your 121 exclusion is gone. 

    0Reply
  • Tony Kim
    Rental Property Investor · Los Angeles · Member since 2018 · 844 posts · 1k+ votes
    6y
    Originally posted by @Corey M.:

    As noted in another post, I'm considering renting out my LA condo, which will be cash flow negative in the range of $500/mo. I bought the house for $320k with 20% down, did a cash out refi recently and got a new $420k loan. That means there's about $230k in equity left in the home. 

    If I rent it out, it'll be at around $3k/mo, but with all expenses, it'll cost me $500/mo, so I'll be losing $6k year in cash. Assuming the property conservatively appreciates by 3%/yr, does this move make sense over a turnkey (not that I only want a passive investment) with an ROI of about 17% (including cash flow, appreciation, and house paydown)?

    My understanding is that I can no longer get the $250k cap gains exclusion if I move out and don't live in the place in three years. But what if I want to keep this as a long term rental property and sell it in a decade? Am I out of luck and have to pay taxes on what would've been a $250k exclusion? To me, renting out the primary residence only makes sense if I can do it for the long term, especially when housing prices could drop 10-20%+ in one year (like they did around 2007 in LA). 

    Assuming I can afford to lose $6k/yr on the negative cash flow, is turning this into a longterm rental going to be a bad decision if I don't plan on selling it within three years? Is there any way to hold onto that $250k exclusion if it's a long term rental? 

    I think this is a bad decision, but not because you'd be a relinquishing the section 121 deduction. I'd recommend against it because you are projected to have a negative cash flow. I know that part of this is offset with principal mortgage pay down, but it just does not make sense to convert this to a rental while absorbing neg cash flow.

    With that said, since your original question was asked under the assumption that you would be fine with absorbing the monthly neg cash-flow, I think a reasonable alternative might be to convert it to a rental for a few years and see how it goes. After a few years you can make the decision whether or not you want to sell.

    I also converted my LA condo into a rental several years ago. When the 3-year point was approaching, we took a hard look at our options and decided to keep it as a rental. In hindsight, it was one of the best decisions I ever made. But, the property also had significant positive cash flow....so we didn't mind holding on to it indefinitely. We exchanged that condo for a multi-unit in South LA a few years ago.

    1Reply
  • Account Closed
    Member since 2019 · 3 posts · 0 votes
    6y

    @Corey M.

    See bullet 3 below

    Source: https://www.nerdwallet.com/article/taxes/selling-home-capital-gains-tax

    Your $250,000 or $500,000 exclusion typically goes out the window, which means you pay tax on the whole gain, if any of these factors are true:

    - The house wasn’t your principal residence.

    - You owned the property for less than two years in the five-year period before you sold it.

    - You didn’t live in the house for at least two years in the five-year period before you sold it. (People who are disabled, and people in the military, Foreign Service or intelligence community can get a break on this part, though; see IRS Publication 523 for details.)

    You already claimed the $250,000 or $500,000 exclusion on another home in the two-year period before the sale of this home.

    - You bought the house through a like-kind exchange (basically swapping one investment property for another, also known as a 1031 exchange) in the past five years.

    You are subject to expatriate tax.

    0Reply
  • Corey M.
    OP
    Member since 2020 · 106 posts · 32 votes
    6y
    Originally posted by @Account Closed:

    @Corey M.

    See bullet 3 below

    Source: https://www.nerdwallet.com/art... $250,000 or $500,000 exclusion typically goes out the window, which means you pay tax on the whole gain, if any of these factors are true:

    - The house wasn’t your principal residence.

    - You owned the property for less than two years in the five-year period before you sold it.

    - You didn’t live in the house for at least two years in the five-year period before you sold it. (People who are disabled, and people in the military, Foreign Service or intelligence community can get a break on this part, though; see IRS Publication 523 for details.)

    You already claimed the $250,000 or $500,000 exclusion on another home in the two-year period before the sale of this home.

    - You bought the house through a like-kind exchange (basically swapping one investment property for another, also known as a 1031 exchange) in the past five years.

    You are subject to expatriate tax.

    If I convert the primary to an investment property and lose the exemption, can I use the 1031 exchange to shield me from paying taxes? How would that work?
    0Reply
  • Account Closed
    Member since 2019 · 3 posts · 0 votes
    6y

    @Corey M.

    I don’t see why not. On paper it sounds legit but I would definitely consult a tax professional first. If you find out be sure to let us know.

    0Reply
  • Dave FosterBusiness Member
    Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
    6y

    @Corey M., You will get whatever exemption you qualify for.  If you have still lived in the property for 2 out of the 5 years prior to the sale and have not taken another primary exemption within 2 years you will get that (but have to recapture depreciation)

    If the property is being used for investment it will be eligible for a 1031 exchange.  You will get to defer indefinitely both gain and depreciation recapture.

    If the property qualifies for both you can use both at the same time.  Take the tax free exemption for the primary residence.  And do a 1031 to defer any remaining tax and all the depreciation recapture.

    The 1031 Investor5137 Reviews
    WebsiteView Page
    1Reply
  • Alex Olson
    Real Estate Broker · Kansas City Metro · Member since 2015 · 2k+ posts · 1k+ votes
    6y

    @Corey M. My recommendation would be to sell your condo and either 1031 and or tax defer any gains you had on the property into an investment property that cash flows. The CA market is pretty tough for that but you can do it in the midwest. You can also do it with long distance investing. David Greene's book on Long Distance Real Estate Investing is an excellent resource for starters. You need to find a really great team on the ground in the market you select. Of course I am partial to KC as I have helped a lot of out of state investors, in particular, CA get what they need out of their investments - from lending and PM to attorney's and insurance. Hope that helps with your decision!

    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free